Credit Derivatives: A crystal ball for treasury managers?

by Farooq Jaffrey, CEO, Traccr Limited

Credit default swaps (CDS) are rapidly becoming a vital risk measurement tool in treasury management. Credit spreads, and their rise or fall, provide a real-time barometer to measure and assess counterparty risk. Screen-based credit pricing is increasingly important to businesses which have historically relied on traditional methods of measuring credit risk to suppliers, customers, debtors and bank counterparties.

Business is based on credit. In order to manufacture, trade or grow, a company needs access to working capital and companies are generally both borrowers and lenders. Finance directors are adept at understanding how financing costs and counterparty risk can impact the financial integrity of their company. After several years of a relatively benign economic environment and easy access to capital the importance of measuring counterparty risk accurately is now recognised as a top priority.

The well documented Great Credit Crackup of 2007 was indiscriminate and many experienced financiers, traders and companies were caught unprepared. Bankruptcies, credit lines pulled, bailouts and malfunctioning capital markets had a previously unimaginable ripple effect. A meteorologist can use digital satellite imaging to assess conditions far enough in advance to evacuate and save people from a natural disaster but no one predicted the catalyst that finally triggered the credit implosion and sent worldwide markets into freefall.

However, if you had looked carefully, in the right place, there were ominous signs that a perfect storm was brewing. That place was the credit derivative markets, where professional traders research, lend and trade the credit quality of companies. While equity investors were snoozing in the comfort of a long bull run and traditional debt investors number-crunched to ‘AAA’ using black-box ratings models, savvy credit traders had the eye of the storm in their sights and were boarding up windows and piling up sand bags in anticipation.

Valentine’s Day Massacre

In early 2007, CDS spreads started to show unsettling signs. On 14 February, a sudden drop in price of Markit ABX-HE-AAA 06-2 (a credit derivative index representing 2006 vintage of securitised US mortgage loans) was aptly dubbed the ‘Valentine’s Day Massacre’ as credit traders suffered sudden mark-to-market losses as they instinctively pulled billions of dollars’ worth of transactions. It later developed that some insightful credit traders had started shorting this index in large volumes in anticipation of a deterioration of credit quality in the US housing market. While equity markets continued their run credit traders and risk managers stepped back to re-assess the implications that this event had on their forecasts for the US and other economies.

In late June the first shoe dropped. Two credit hedge funds at a fabled investment bank began to teeter on the edge as banks pulled their credit lines. Troubling rumours of banks having difficulty off-loading illiquid CDO and subprime positions were rife. As investors began to ask more questions, markets from trade finance to credit card securitisations slowly ground to a halt. Now both credit traders and investors were hedging en masse, sending CDS on mortgage backed securities and corporates even wider. (An increase in spread, or CDS premium, corresponds to a decrease in price.)